The Difference Between Private Equity and Mutual Funds

When you buy shares in a mutual fund, you are both protected and limited by the Investment Company Act of 1940. This Congressional Act was aimed to root out the causes of the Stock Market Crash of 1929 and subsequent Great Depression by placing significant constraints on the ability of fund promoters to scam the individual investors they contact.

When you buy a mutual fund, there are certain guarantees that you receive: (1) the shares of the fund you buy are registered with the SEC; (2) the fund must have a board of directors, and 75% of those directors must be independent from the managers of the fund that individually select the investments; (3) the fund must refrain from directly managing its investment holdings and must function as a passive investor; (4) the fund must limit the amount of leverage it employs and must have certain cash on hand to cover redemptions, usually 3%; and (5) must provide quarterly data for an N-SAR form that gives details about the individual holdings, expense ratio, and investment objectives of the fund. Also, the fund faces diversification requirements unless it “conspicuously” advertises to the contrary.

By and large, these stringent requirements have served mutual fund investors well. Since the launch of the modern day mutual fund over a half-century ago, the only mutual fund to ever approach $0 was the Steadman fund. That fund was run by a terrible investor named Charles Steadman who failed to properly register his fund and faced SEC hearings over his non-disclosure of conflicts of interests and billed the legal costs to the fund which created an expense ratio of 25%. Because a quarter of the fund’s value was being siphoned off to pay lawyers, Steadman advertised that the fund would no longer diversify and then invested half of the fund into Intel warrants at the top of tech bubble right before the stock plummeted. That’s how you destroy $7.3 million in capital over forty years.

But what is notable is that the Steadman family of funds is the exclusive fund I can point to out of tens of thousands to show complete capital loss. An average of 322 publicly traded corporations listed on global stock exchanges go bankrupt each year. The fact that only 1 fund family out of the more than 300,000 mutual funds that have existed in history have met a similar fate of total capital loss speaks to the strength of the mutual fund model in mitigating downside.

Of course, while mutual funds do an excellent job of mitigating the downside, they are less useful for capturing the upside of extreme compounding. Less than 1% of mutual funds that have existed for twenty years of more have pre-tax compounding rates of over 12%.

What happens if you are a venturesome investor that wants to pursue double-digit returns? This is the target audience that is served by private equity investments.

Private equity is distinguishable from mutual funds because they are not readily marketable or liquid (they don’t trade on exchanges and can contain lock-up provisions that prevents sale for a certain period of time). Also, they don’t have the transparency requirements of mutual funds. This is because unlike mutual funds, private equity investments permit control of the investment. If the Vanguard Wellington Fund buys shares of Marathon Petroleum, it can’t install a Vanguard Wellington manager as CEO of the company. But if Kayne Anderson Energy Private Equity buys shares of Marathon Petroleum, it is not legally forbidden from trying to install its own management team at the oil company or leveraging up to buy enough shares to make that happen.

With private equity, you can secure control and then tack on enormous amounts of debt. When Mitt Romney and a group of investors at Bain Capital took over Domino’s for $1.1 billion, they only contributed a little under $400 million. Then they borrowed over a billion dollars to repurchase stock and give themselves a $900 million dividend. They reaped a 531% return in under twelve years by recognizing that they could maximize the debt because the franchisees had to make all the ongoing capital improvement investments and they could sell their investment during a time of low-ish interest rates in which high debt burdens didn’t hamper valuations as you might think they should.

The drawback of the private equity method is that it often leaves a mess for other people to clean up. By the time Bain cashed out, Domino’s carried the highest debt burden of any national pizza chain. From 2008 through 2016, Domino’s had to use some of its cash flows to pay down its debt interest and make inroads on its principal. It also needed to redo its pizza formula in 2009 after years of neglect that found the pizza chain ranking last in taste among national brands. But given that the private equity investing usually involves a holding period of five to seven years, it falls on the subsequent owners of the business to address the excess of the private equity model.

In addition to direct ownership, private equity investors differ from mutual funds in that they can lend directly to their portfolio companies. Using our Marathon Petroleum example above, it is possible for an energy private equity fund to engage in mezzanine financing in which they, say, lend the oil company $300 million at 7.5% for five years and attach an equity conversion clause to the contract. If Marathon Petroleum cannot repay the principal five years later, it will have to issue shares to the private equity firm at a predetermined price that is usually attractive to the private equity company.

From a technical perspective, the difference between a private equity investment and a mutual fund centers around disclosure and diversification requirements, degree of control permitted in the portfolio companies, and the amount of allowable leverage. In a typical scenario, the lack of available leverage usually means that a mutual fund investment has lower upside but greater protection on the downside while a private equity investment contains greater wipeout risk in the pursuit of double-digit annual gains.

Originally posted 2017-01-07 21:03:59.

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